Nepal as a small open economy declared war on Germany on 4 September 1939, in which its
government purchases increased and the rest of the world\'s government purchases also increased
due the large defense spending. Then, for Nepal, holding others things constant, which of the
following should be correct in the long run (WWII lasted for 6 years from 1939 to 1945)?
A. net exports should decrease.
B. net exports should increase.
C. net exports should remain the same.
D. it depends.
Solution
Increase in government expenditure will have effects on two fronts, on income and on exchange
rate. When government expenditure increase, the income in the economy will also increase, as a
result, people will demand more of import goods. Hence, income effect will lead to decrease in
net export.
On the other hand, increase in government expenditure also cause home currency to depreciate,
which would lead to increase in export. The exchange rate effect will lead to increase in net
export.
Hence, on aggregate the net export will depend on the strength of income effect and exchange
rate effect. The correct answer is D..
Nepal as a small open economy declared war on Germany on 4 September.pdf
1. Nepal as a small open economy declared war on Germany on 4 September 1939, in which its
government purchases increased and the rest of the world's government purchases also increased
due the large defense spending. Then, for Nepal, holding others things constant, which of the
following should be correct in the long run (WWII lasted for 6 years from 1939 to 1945)?
A. net exports should decrease.
B. net exports should increase.
C. net exports should remain the same.
D. it depends.
Solution
Increase in government expenditure will have effects on two fronts, on income and on exchange
rate. When government expenditure increase, the income in the economy will also increase, as a
result, people will demand more of import goods. Hence, income effect will lead to decrease in
net export.
On the other hand, increase in government expenditure also cause home currency to depreciate,
which would lead to increase in export. The exchange rate effect will lead to increase in net
export.
Hence, on aggregate the net export will depend on the strength of income effect and exchange
rate effect. The correct answer is D.
